Small cap shares have enjoyed a surging run this year, leaving value hunters with few options other than wait for fleeting chances to buy into dips or loosen their stock-picking rules. For those with an appetite for micro-cap risk and bargain bucket investing, the very smallest companies in the market could offer some new possibilities - but they come with high risks. Because trawling for the forgotten few can be perilous, we went armed with the bargain investing guidance of Benjamin Graham and some proven tools to find stocks with the best chances of delivering long-term price gains.
You only need look at the performance of small cap indices to see how bullish sentiment has benefitted many market tiddlers in 2013. With the FTSE Fledgling XIT up 50% over 12 months (see chart) and the Alternative Investment Market trading at an 18-month high, it’s clear that smaller companies have seduced many investors. Arguably, however, that makes investing in them all the more difficult because it’s likely that rising markets have inflated prices to unsustainable levels.
Beaten down bargains
One of the big winners from the rush towards small caps has been Stockopedia’s version of Ben Graham’s ‘NCAV’ bargain strategy, which has returned an impressive 42.8% over the past year. This deep value screen aims to buy up stocks that are trading at prices well below the value of their net current assets (NCAV). Graham’s theory was that the market generally throws away stocks that are in trouble or near bankruptcy for a dime. With a wide margin of safety and lots of diversification, Graham realised that he could reap strong gains by buying these misfits as a portfolio. (You can read more about how it works here).
Interestingly, it’s an approach that tends to do extremely well at the zenith of bear markets, when the screen fills up with larger, higher quality companies; currently the population is dominated by much riskier micro-caps with wide spreads. Even so, research into the strategy has consistently shown it to be effective. A 1986 study by US finance professor Henry Oppenheimer, found that in the 13 years to 1983, NCAV stocks produced an average annual return of 29.4% versus 11.5% per year for the NYSE-AMEX Index. Importantly, companies operating at a loss produced slightly higher investment returns than those with positive earnings.
